Bonds Get Cheap on Buyout News

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The leveraged buyout of Dell (NASDAQ: DELL) is the largest since 2007, valued at $24.4 billion. I wrote about the feasibility of this buyout here, coming to the conclusion that the deal was an unlikely one. But the price that I came up with for a potential buyout under an optimistic scenario, $13.87 per share, was very close to the actual buyout price of $13.65 per share. Apparently those behind the deal are more optimistic on a Dell turnaround than I thought. One effect of the buyout is that Dell will be loaded up with debt, so much so that many of Dell's existing bond offerings have plummeted in price. Since the stock is no longer an option to bet on the future of Dell, the bonds now offer an attractive alternative.

A sharp decline

The bond hit hardest by the buyout is the longest-term one, maturing in 2040 and carrying a 5.4% coupon (CUSIP: 24702RAM3). As you can see below, the bond has fallen from $110 to around $80 in a very short amount of time.

Dell 2040 Bond Price

<img src="/media/images/user_13886/dell-finra_large.png" />

Source: Finra

There are two numbers which matter here: the current yield and the yield to maturity. The current yield is simply the annual payment divided by the purchase price. The yield to maturity, a more robust measure, is the annualized return one would achieve by buying the bond at the current price. This includes the effect of the principal payment and, since the price is now lower than par, will be higher than the current yield. My calculations for this bond are below.

 

<img src="/media/images/user_13886/dell-ytm-tip_large.png" />

<img src="/media/images/user_13886/dell-ytm-bottom_large.png" />

The recent drop in price has raised the yield to maturity from about 5% to 7.25%, a 50% increase in annualized return. This compares well to the 30-year US treasury, currently yielding about 3.2%.

PC bond alternatives

Of all bonds issued by manufacturers of PCs this Dell bond looks like the best bet. Hewlett-Packard (NYSE: HPQ), which has far more debt outstanding than pre-buyout Dell, has a bond maturing in 2041 (CUSIP: 428236BR3) with a yield to maturity of 6.5%. This HP bond trades at roughly par while the Dell bond is nearly 20% below par.

One component of the Dell buyout is that Microsoft (NASDAQ: MSFT) will provide $2 billion in loans to fund the buyout. Microsoft has some outstanding bonds, but all of them are well above par and offer poor yields. A comparable bond to the Dell bond, one maturing in 2040 (CUSIP: 594918AJ3), has a yield to maturity of just 4.165%. That's not much better than a US treasury bond and is only slightly higher than Microsoft's 3.29% dividend yield.

Default risk

The pre-buyout Dell had a total outstanding debt of about $9 billion along with $14 billion in cash. The buyout will add something like an additional $15 billion in new debt, leaving a total debt of $24 billion. Dell recorded $3.1 billion in FCF in the TTM period and $4.8 billion in 2011. As long as Dell can stabilize its cash flows this should easily cover interest payments. The cash position is also a big plus. This makes me believe that the default risk is fairly low for Dell, even with the massive amount of new debt.

HP has $28.4 billion in debt and $11.3 billion in cash, a net debt position of $17.1 billion. The company paid $876 million in interest last year on this debt compared to a free cash flow of $6.8 billion. This cash flow has severely deteriorated since 2008, dropping from $11.6 billion. It's unclear when HP will be able to stabilize its cash flows, but currently debt payments are not a problem. The default risk here is also low, although the long-term nature of the bond introduces some uncertainty.

Microsoft has a fortress balance sheet, $14 billion in debt and $79 billion in cash and investments. Microsoft generated $27 billion in FCF in the TTM period. The Microsoft bond is about as safe in terms of default risk as a bond gets. Of course, the low yield makes it unattractive compared to the Dell or the HP issue. 

The bottom line

The Dell buyout has created an opportunity to buy Dell bonds at a price roughly 25% less than pre-buyout levels. This price drop has raised the YTM on the bond over 7%, which is higher than any PC-related bond you can find. These bonds are a bet that Dell will be able to succeed as a private company, turning around declining profits away from the pressures of the stock market. Only time will tell if taking the company private will pay off.


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